Friday, September 14, 2012

Why early sovereign default could save the euro

Redistributive battles

The Eurozone has so far studiously avoided the default option, with the exception of the half-hearted Greek restructuring, where denial of the problem was no longer possible. Instead it has embarked on two transfer strategies that will worsen the Eurozone crisis.

The first consists in public bailout schemes, such as the EFSF or the ESM, which replace private credit with public credit of the still-solvent states.

The debt overhang problem of some countries thereby becomes the debt overhang problem of all the others, without any net relief for the Eurozone as a whole. Needless to say: private investors do not have any confidence that this strategy will work for the Eurozone. But they support it enthusiastically, for it allows them to transfer their credit risk to Eurozone taxpayers. Substantial policy pressure from the US, UK, and China supports such a risk transfer in pursuit of investor interests.

The second futile policy consists of central bank purchases of distressed sovereigns’ bonds.

The declared goal of this programme is to reduce yields on outstanding debt with such purchases and thus reduce the cost of issuing new debt. But this argument contradicts the cold reality of bond valuation. As long as distressed sovereigns continue to issue new debt, they will still have to pay a large default premium. This premium is augmented by the ECB’s seniority. Investors anticipate that if the issuer defaults, the central bank would always be first in the recovery queue. ECB bond buying will therefore have no lasting positive effect on sovereigns’ financing costs.

Why are bond purchases so strongly advocated by southern countries in the Eurozone? It is essentially a 21st century version of beggar-thy-(Eurozone)-neighbour: Through massive bond buying, the ECB will accumulate considerable sovereign default risk which is then shared by all Eurozone members. Ironically, rather than reducing the risk of sovereign default, the ECB’s bond buying will eventually produce the opposite effect. The larger the scale of sovereign debt transfers from domestic investors to the ECB, the less will there be domestic resistance against default. ECB policy might delay sovereign default, but does not make it less likely.

Early debt restructuring as a policy alternative

While many central bankers and policymakers are still in denial, time is running out to address the real problem of Europe's debt overhang. The Greek example has shown how sovereign debt can be restructured without the market upheaval and contagion predicted by many (Landon 2012). The legal instruments can be put in place for Spain, Portugal, Italy, or other countries to undertake exchange offers of existing debt with new debt which include reductions of the principal and postpone interest payments. With primary deficits near zero, such debt restructuring is a real policy alternative. It has proven workable in previous cases, such Uruguay in 2003 (Buchheit and Pam 2004). The historical evidence from the large number of previous sovereign default episodes tends to show that the economic costs are short-lived (Borensztein and Panizza 2009).

Ultimately, the Eurozone will have to choose between sovereign default through debt restructuring and default on the real value of government bonds through inflation. Debt restructuring has many advantages if it is undertaken at an early stage.

Through orderly default, investors take responsibility for their investment decisions. This is not the case if they are bailed out via debt socialisation. Debt restructuring in the Eurozone would typically come with onerous conditions for borrowers, whereas excess inflation provides an easy windfall to all debtors. Thus, moral hazard for creditors and for debtors is attenuated.

Debt restructuring puts a much larger fraction of the financial burden on financial investors outside the Eurozone, whereas debt mutualisation bails out financial investors worldwide at the cost of Eurozone taxpayers.

Given the extremely high concentration of financial wealth, losses in any sovereign default will fall mostly on wealthy investors (as bank shareholders or bond investors typically are). By contrast, when debt is mutualised, middle-class taxpayers, the main source of tax revenues in the Eurozone countries, will have to bear a much larger fraction of the burden (Hau 2011).

Bailout schemes, as in the case of Greece, Portugal, Ireland, and soon Spain, come with politically sensitive external monitoring over an extended period of time. Orderly sovereign default in the Eurozone is likely to be linked to external conditions as well, but by reducing the transfers from over-indebted countries to their creditors, it removes one of the most poisonous elements of this process.